Should we be worried about stock-market illiquidity?

When volatility rises, so do bid-offer spreads. That’s entirely natural — volatility means danger, and a higher chance that the market will move against you if you’re a market-maker. So you require a bigger spread between your bid and offer prices before you’re willing to trade.

But does that mean, in the words of the WSJ, that “cracks are appearing deep in the workings of the stock market”? And looking at the chart above, would you agree with this?

In some ways, investors would be expected to leave the market in uncertain times, but traders say the exodus of late is striking and underscores the nervousness of market participants, and the lack of willingness of many to step in to trade.

it seems to me that insofar as illiquidity is something separate from volatility, bid/ask spreads have actually been less volatile than the VIX.

And I’m far from convinced that bid/ask spreads in the 4-5bp range are particularly harmful. Not so long ago, remember, NYSE stocks traded in eighths of a dollar — which means that on a $20 stock, the smallest possible bid/ask spread was more than 60bp. And Europe is going so far as to try to increase the cost of trading: its mooted financial transactions tax is being pegged at about 10bp.

Large investors always complain that they can’t get good execution, in much the same way that large exporters always complain that their currency is too strong. When bid/ask spreads go up, they complain about that; when bid/ask spreads go down, they complain that they can only trade in small size at the quoted spreads.

It’s worth remembering, too, that the kind of liquidity measured by bid/ask spreads — the minute-to-minute and second-to-second ability to buy or sell as much stock as you want without moving the market — is precisely the kind of thing that high-frequency trading shops exist to provide. If you want to encourage that kind of liquidity, fine — but the flipside of doing so is always that they risk disappearing the minute you actually need them.

Overall, stock-market liquidity concerns are pretty much the least of my worries right now. We managed to navigate all the way through the financial crisis without any real liquidity problems in the stock market at all, and even on its worst days, today’s stock market is vastly more liquid than it was, say, a decade ago during the dot-com boom and bust.

Indeed, the anecdotes purportedly demonstrating the market’s illiquidity say something very different to me:

One well-known manager of a large hedge fund said he recently tried to buy $250 million of shares of Tempur-Pedic International Inc., a mattress maker with a nearly $4 billion market value. The manager, who declined to speak on the record, says he gave up after his initial order of $20 million of shares pushed prices of the stock up too far.

What we’re seeing here is someone trying to take a very large stake of more than 6% in Tempur-Pedic — and expecting to do so without moving the price much. In an efficient market, someone making such a big play in a company should move the market upwards. When a big buyer comes in to the market, prices go up. That’s how markets are meant to work.

At some point in the future, if the ETF craze continues to grow at its current pace, it’s possible that so much trading will be taking place in ETFs that individual stocks are going to become harder and harder to trade. That’s a theoretical worry. But it hasn’t happened yet. Instead, we’re just seeing markets behave entirely rationally, with bid/ask spreads reflecting broader stock-market volatility. That’s not a cracked market. It’s an efficient one.